Microeconomics Notes

VIETNAM ECONOMICS OLYMPIAD

Introduction to Economics

• The Foundations of Economics
  • A fundamental problem in economics is the tension between unlimited economic wants and limited economic resources.
  • Society’s economic wants refer to the desires of its citizens and institutions.
  • Economic resources are the means of producing goods and services (labor, capital, natural resources, etc.).
• What is Economics?
  • Economics studies how a society manages its scarce resources to fulfill the needs and wants of its people.
  • It is concerned with the efficient use of scarce resources to achieve the maximum satisfaction of economic wants.
• Scarcity and Choice
  • Scarcity implies that there are not enough resources to produce all the goods and services that people want.
  • Choice is necessary because "we can’t have it all" and must decide what to forgo.
  • Opportunity cost is what you give up to obtain something else; it is the next best alternative forgone.
• Three Basic Economic Questions
  • What to produce? This involves decisions about the types of goods and services a society chooses to produce.
  • How to produce? This involves decisions about the technology used to produce goods and services.
  • For whom to produce? This involves decisions about how goods and services are distributed among people.
• Economic Systems
  • An economic system is a particular set of institutional arrangements and a coordinating mechanism.
  • Economic systems differ based on who owns the factors of production and the method used to coordinate and direct economic activities.
• Types of Economic Systems
  • Market economy: Characterized by private ownership of resources and the use of markets and prices to coordinate economic activities.
  • Command economy: Resources are owned by the government, and economic decision-making occurs through a central economic plan.
  • Mixed economy: A combination of market and command economy features where both the government and the private sector jointly solve economic problems.
• Microeconomics and Macroeconomics
  • Microeconomics examines specific economic units and the behavior of individual economic units such as consumers, firms, investors, and workers, as well as individual markets.
  • Macroeconomics studies the aggregate behavior of the economy, seeking an overview or general outline of the structure of the economy and the relationships of its major aggregates.
• Tools of Economics
  • Models are simplifications of reality that omit many details to allow us to see what is truly important.
  • Economic models are composed of diagrams and equations that show relationships among economic variables.
  • "All models are wrong, but some models are useful."

Market Analysis

Demand

• Demand is the amount of a good or service consumers are willing and able to purchase at each price.
• A demand schedule is a table that shows the relationship between the price of a good and the quantity demanded.
• A demand curve is a graphical representation of the relationship between the price of a good and the quantity demanded. Illustration provided with price per kg of apples vs. quantity demanded. Law of Demand
  • The law of demand states that, all else equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls.
• Demand vs. Quantity Demanded
  • Demand describes the behavior of a buyer at every price (i.e., the entire demand curve).
  • Quantity demanded is a particular quantity that is demanded at a specific price.
  • A movement along the demand curve represents a change in quantity demanded caused by a change in the price of the product.
  • A shift of the demand curve represents a change in demand.
    • Increase in demand: The demand curve shifts to the right.
    • Decrease in demand: The demand curve shifts to the left.
• Determinants of Demand
  • Determinants of demand are factors that cause the demand curve to shift; also called demand shifters. These include:
    • Consumers’ tastes and preferences
    • Consumers’ income
    • The prices of related goods
    • Expectations
    • Number of buyers
    • Weather
• Income and Demand
  • Normal goods: Products whose demand varies directly with income. As income increases (decreases), the demand for a normal good will increase (decrease).
  • Inferior goods: Products whose demand varies inversely with income. As income increases (decreases), the demand for an inferior good will decrease (increase).
• Prices of Related Goods
  • Substitute goods are goods that are similar to one another and can be consumed in place of one another. When the price of a good falls (rises), the demand for its substitute good decreases (increases).
  • Complementary goods are goods that are consumed in conjunction with one another. When the price of a good falls (rises), the demand for its complementary good increases (decreases).

Supply

• Supply is the amount of a product that producers are willing and able to sell at each price.
• A supply schedule is a table that shows the relationship between the price of a good and the quantity supplied.
• A supply curve is a graphical presentation of the relationship between the price of a product and the quantity supplied. Presentation includes a Producer’s Supply of Apples Example, detailing price per kg vs quantity supplied. Law of Supply
  • The law of supply states that, all else equal, as price rises, the quantity supplied rises, and as price falls, the quantity supplied falls. There is a positive or direct relationship between price and quantity supplied.
• Supply vs. Quantity Supplied
  • Supply describes the behavior of a seller at every price (i.e., the entire supply curve).
  • Quantity supplied is a particular quantity that is supplied at a specific price.
  • A movement along the supply curve represents a change in quantity supplied caused by a change in the price of the product.
  • A shift in the supply curve represents a change in supply.
    • Increase in supply: The supply curve shifts to the right.
    • Decrease in supply: The supply curve shifts to the left.
• Determinants of Supply
  • Determinants of supply are factors that cause the supply curve to shift; also called supply shifters. These include:
    • Resource prices
    • Technology
    • Taxes and subsidies
    • Prices of other goods
    • Expectations
    • Number of sellers
    • Weather

Market Equilibrium

• Market equilibrium is achieved at the price at which quantities demanded and supplied are equal.
• It is established at the intersection of demand and supply curves.
• Market equilibrium determines the equilibrium price $P^<em>$ and equilibrium quantity $Q^</em>$.
• Exercises
  • Example: Demand and supply functions are given as $Q<em>D = 120 - 2P$ and $Q</em>S = 20 + 3P$. Calculate the equilibrium price and quantity.

Market Analysis

• Market analysis is the study of fluctuations in market price and quantity as a result of changes in market conditions.
• Market equilibrium changes when there is a change in market conditions, such as a change in supply, a change in demand, or changes in both.
  Visual depictions of Market Analysis with supply and demand curves are included, showcasing changes in demand and supply. Change in demand is depicted in a graph in which there are shifts in the demand curves(D1, D, D2) shifting the original equilibrium point(E) to E1 or E2.
• Change in supply is depicted via a graph in which S1, S and S2 are shown as shifts in the supply curve leading to different equilibrium points.
• Change in both demand and supply encompasses scenarios like:
  • Increase in demand and decrease in supply
  • Increase in demand and increase in supply
  • Decrease in demand and increase in supply
  • Decrease in demand and decrease in supply

Government Controls on Prices

• In a free, unregulated market system, market forces establish equilibrium prices and quantities.
• Sometimes the government believes that the market price is unfair to buyers or sellers, so it may place legal limits on prices.
• The result is government-created price ceilings and floors.
• Price Ceilings and Price Floors
  • Price ceiling: A legal maximum on the price at which a good can be sold; it creates a shortage.
  • Price floor: A legal minimum on the price at which a good can be sold; it creates a surplus.
• Exercises
  • Example: Demand and supply functions are given as $Q<em>D = 120 - 2P$ and $Q</em>S = 20 + 3P$. If the government imposes a price ceiling of 18, what will happen?

Elasticity

• Elasticity allows us to analyze supply and demand with greater precision.
• Elasticity is a measure of how much buyers and sellers respond to changes in market conditions.
• Price Elasticity of Demand
  • The price elasticity of demand measures the responsiveness of quantity demanded to changes in price.
  • It is computed as the percentage change in quantity demanded divided by the percentage change in price.
  • Formula for price elasticity of demand:
    $E<em>P = \frac{\frac{\Delta Q}{(Q</em>1 + Q<em>2)/2}}{\frac{\Delta P}{(P</em>1 + P<em>2)/2}} = \frac{\% \Delta Q}{\% \Delta P}$ Another Formula: $E</em>P = \frac{\Delta Q}{\Delta P} \times \frac{P}{Q} = Q' \times \frac{P}{Q}$
    $E_P = \frac{\%Q}{\%P}$
• Example
  • If the price of an ice cream cone increases from $2.00 to $2.20, and the amount you buy falls from 10 to 8 cones, then what would be your elasticity of demand?
• Types of Price Elasticity of Demand
  • Elastic Demand: Percentage change in quantity demanded is greater than percentage change in price. E_P > 1
  • Inelastic Demand: Percentage change in quantity demanded is less than percentage change in price. E_P < 1
  • Unit Elastic: Percentage change in quantity demanded is equal to percentage change in price. $E_P = 1$
  • Perfectly Inelastic: Quantity demanded does not change as price changes. $E_P = 0$
  • Perfectly Elastic: A small percentage change in price causes an extremely large percentage change in quantity demanded. $E_P = \infty$
• Price Elasticity of Demand and the Shape of the Demand Curve
  • Visual representations showing perfectly inelastic, inelastic, unit elastic, elastic, and perfectly elastic demand curves.
• Price Elasticity and Total Revenue
  • Total revenue is the amount that a seller receives from the sale of a good.
  • Total revenue is computed as the price of the good times the quantity sold: $TR = P \times Q$
  • When demand is elastic:
    • An increase in price results in a decrease in total revenue.
    • A decrease in price results in an increase in total revenue.
  • When demand is inelastic:
    • An increase in price results in an increase in total revenue.
    • A decrease in price results in a decrease in total revenue.
  • When demand is unit elastic: A change in price results in no change in total revenue.
• Cross Price Elasticity of Demand
  • Cross price elasticity of demand is a measure of the responsiveness in quantity demanded of one good to changes in the price of another good.
  • It is computed as the percentage change in quantity demanded of one good (X) divided by the percentage change in the price of another good (Y).
• Relationship Between Goods
  • Substitute goods: If the cross price elasticity of demand is positive, then X and Y are substitute goods. E_{X,Y} > 0
  • Complementary goods: If the cross price elasticity of demand is negative, then X and Y are complementary goods. E_{X,Y} < 0
  • Unrelated goods: If the cross price elasticity of demand is zero, then X and Y are unrelated. $E_{X,Y} = 0$
• Income Elasticity of Demand
  • Income elasticity of demand is a measure of the responsiveness in quantity demanded to changes in income.
  • It is computed as the percentage change in the quantity demanded divided by the percentage change in income.
• Types of Goods
  • Normal goods: Those goods that have a positive income elasticity of demand. Higher income raises the quantity demanded for normal goods.
  • Inferior goods: Those goods that have a negative income elasticity of demand. Higher income lowers the quantity demanded for inferior goods.
  • Goods consumers regard as necessities tend to be income inelastic: E_I < 1. Examples include food, fuel, clothing, utilities, and medical services.
  • Goods consumers regard as luxuries tend to be income elastic: E_I > 1. Examples include sports cars, furs, and expensive foods.
• Price Elasticity of Supply
  • Price elasticity of supply is a measure of the responsiveness of quantity supplied to changes in price.
  • The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.
• Types of Supply Elasticity
  • Elastic supply: The price elasticity coefficient is greater than 1.
  • Inelastic supply: The price elasticity coefficient is less than 1.
  • Unit elastic supply: The price elasticity coefficient is 1.
  • Perfectly inelastic supply: The price elasticity coefficient is zero.
  • Perfectly elastic supply: The price elasticity coefficient is infinite.

The Theory of Consumer Choice

• Theory of consumer behavior describes how consumers allocate incomes among different goods and services to maximize their well-being.
• Consumer behavior can be broken down into three distinct steps: budget constraints, consumer preferences, and consumer choices.
• Budget Constraints
  • Budget constraint represents what the consumer can afford, limited by their income.
  • The equation for the budget constraint is given by $P<em>X \cdot X + P</em>Y \cdot Y = I$ where:
    • $P_X$ is the price of good X.
    • $P_Y$ is the price of good Y.
    • X and Y are the quantities of the goods.
    • I is the consumer's income.
  • Budget line shows all combinations of goods that can be consumed within the budget limit.
    Diagram of a budget line on X and Y axes included. Effects of Changes in Income and Prices
  • Income changes cause a shift in the budget line.
  • Price changes cause a change in the slope of the budget line.
• Consumer Preferences
  • Consumer preferences reflect what the consumer wants.
  • Basic assumptions about preferences:
    • Completeness: Consumers can compare and rank all possible market baskets (bundles) of goods.
    • Transitivity: Preferences are transitive (if A is preferred to B, and B is preferred to C, then A is preferred to C).
    • More is better than less: More of any good is preferred to less.
• Utility
  • The satisfaction or pleasure one gets from consuming a good or service is called utility.
  • Total utility (U) is the total amount of satisfaction a person receives from consuming a particular quantity of a good. $U = U(Q)$
  • Marginal utility (MU) is the additional utility a person receives from consuming one more unit of a good. $MU = \frac{\Delta U}{\Delta Q}$
• Law of Diminishing Marginal Utility
  • The law of diminishing marginal utility states that the marginal utility gained by consuming additional units of a good will decline as more of the good is consumed. As Q increases, MU decreases.
• Indifference Curves
  • The consumer’s preferences are represented with indifference curves.
  • An indifference curve shows all combinations of goods that provide a consumer with the same level of satisfaction.
    Illustration included displaying Indifference Curves. An indifference map contains U1, U2, U3 with U3 indicating higher satisfaction. Marginal Rate of Substitution (MRS)
  • Marginal rate of substitution (MRS) is the amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good while remaining at the same level of satisfaction.
  • MRS is the slope of the indifference curve.
• Properties of Indifference Curves
  • Higher indifference curves are preferred to lower ones.
  • Indifference curves are downward sloping.
  • Indifference curves do not cross.
  • Indifference curves are bowed inward (convex).
• Consumer’s Optimal Choice
  • Optimization is what the consumer chooses.
  • Consumers allocate their money incomes among different goods and services to achieve the highest level of satisfaction.
  • Consumer’s optimal choice occurs at the tangency point of the budget constraint and the highest possible indifference curve.
    Illustration of a consumer's optimal choice by tangent of the Budget Line and Indifference Curve. At the consumer’s optimal choice, the slope of the indifference curve is equal to the slope of the budget constraint.
    $MRS = \frac{MU<em>X}{MU</em>Y} = \frac{P<em>X}{P</em>Y}$
• Utility Maximization
  *Utility maximizing combination of goods occurs when $MU<em>X/P</em>X = MU<em>Y/P</em>Y$
• How Changes in Income Affect the Consumer’s Choices
  • When income changes, the budget constraint shifts.
  • Normal good: A good for which an increase in income raises the quantity demanded.
  • Inferior good: A good for which an increase in income reduces the quantity demanded.
• How Changes in Prices Affect the Consumer’s Choices
  • A fall in the price of a good has two effects:
    • Substitution effect: Consumers tend to buy more of the good that has become cheaper and less of the good that is relatively more expensive. This is the change in consumption of a good associated with a change in its price, with the level of utility held constant.
    • Income effect: Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power. This is the change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant.

The Theory of the Firm: Production and Costs

• What is a Firm?
  • A business firm is an entity that employs factors of production (resources) to produce goods and services to be sold to consumers, other firms, or the government.
• The Objective of the Firm
  • A business firm has a revenue side (total revenue) and a cost side (total cost).
  • Total revenue is the amount of money the firm receives from the sale of its product.
  • Total cost is the costs that the firm incurs for the use of inputs.
  • Profit is the difference between total revenue and total cost. $\pi = TR - TC$
  • The firm’s objective is to maximize its profit.
• Production Function
  • Production is a process of transforming inputs into output.
  • The production function shows the maximum quantity of output that can be produced from a given amount of various inputs. $Q = F(K, L)$
• Short Run Production Relationships
  • Total product (Q) is the quantity or total output of a particular good produced.
  • Marginal product of labor (MPL) is the additional output that the firm can produce when it employs one more unit of labor. $MPL = \frac{\Delta Q}{\Delta L}$
  • Average product of labor (APL) is output per unit of labor input, also called labor productivity. $APL = \frac{Q}{L}$
    Example is given showcasing the relationships with numerical values Short Run Production Costs
  • In the short run, some resources (inputs) are fixed, and other resources (inputs) are variable.
  • Short-run costs may be divided into fixed costs and variable costs.
  • Fixed costs are the costs incurred for the use of fixed inputs.
  • Variable costs are the costs incurred for the use of variable inputs.
• Fixed, Variable, and Total Costs
  • Total fixed costs (TFC) are those costs that do not vary with the level of output produced. Examples include rental payments, interest on the firm’s debt, and insurance premiums.
  • Total variable costs (TVC) are those costs that change with the level of output produced. Examples include payments for materials, fuel, power, and labor.
  • Total costs (TC) are the sum of fixed costs and variable costs at each level of output. $TC = TFC + TVC$
    Example is given showcasing numerical relationships between these values. Average and Marginal Costs
  • Average fixed cost (AFC) is fixed cost per unit of output: $AFC = \frac{TFC}{Q}$
  • Average variable cost (AVC) is variable cost per unit of output: $AVC = \frac{TVC}{Q}$
  • Average total cost (ATC) is total cost per unit of output: $ATC = \frac{TC}{Q} = AFC + AVC$
  • Marginal cost (MC) is the additional cost that the firm incurs when it produces one more unit of output: $MC = \frac{\Delta TC}{\Delta Q}$
    A numerical example is given to showcase the relationships. Cost Curves
    Visual depiction of Cost Curves including MC, ATC, AVC, and AFC. Relation of MC to AVC and ATC
  • The MC curve intersects the ATC curve at its minimum point.
    • When MC is less than ATC, then if Q increases, ATC will fall.
    • When MC is higher than ATC, then if Q increases, ATC will rise.
  • The MC curve intersects the AVC curve at its minimum point.
    • When MC is less than AVC, then if Q increases, AVC will fall.
    • When MC is higher than AVC, then if Q increases, AVC will rise.
• Shifts of Cost Curves
  • Cost curves will shift when there is a change in:
    • Taxes and subsidies
    • Input prices
    • Technology
• Long Run Production Costs
  • In the long run, a firm can adjust all its resources; all inputs are variable.
  • In the long run, there are no fixed costs; all costs are variable costs.
  • Total costs = Total variable costs
• The Long Run Cost Curve
  • The long-run ATC curve (the firm’s planning curve) shows the lowest average total cost at any level of output produced.
  • It is the envelope of all possible short-run ATC curves.
    Visual depiction of Long Run Average Costs inlcuding Average Total Cost, LRATC, and LMC. Economies of Scale, Constant Economies of Scale, and Diseconomies of Scale
  • The long-run average cost curve displays 3 regions:
    • Economies of scale: Long-run average total cost falls as the quantity of output increases.
    • Constant returns to scale: Long-run average total cost is unchanged as the quantity of output increases.
    • Diseconomies of scale: Long-run average total cost rises as the quantity of output increases.
  • The minimum efficient scale (MES) is the level of output at which a firm can minimize its long-run average total cost.

Market Structures

• Market structure is a set of market characteristics that determines the economic environment in which a firm operates.
• It describes the competitive environment of the market.
• Market structure depends on:
  • The number and relative size of firms in the industry.
  • The degree of product similarity or differentiation.
  • Conditions of entry and exit.
• Types of Market Structures
  Visual depiction of Market Structure Spectrum: Monopoly, Oligopoly, Monopolistic competition, and Perfect competition. Monopoly: Tap water, Railways. Oligopoly: Airlines, Cars, Computers. Monopolistic competition: Restaurants, Books, Movies. Perfect competition: Agricultural products.
• Perfect Competition
  • Characteristics of perfect competition:
    • Numerous small firms: there are many firms, and each firm is relatively small in size.
    • Standardized product: the product is identical or homogenous.
    • Free entry and exit: there are no barriers to entry or exit the market.
    • Perfect information: sellers and buyers have full access to information regarding the product.
    • Price taker: each firm is a price taker and can sell as much product as it wants at the market price. Each firm has no market power.
• Demand as Seen by a Perfectly Competitive Firm
  • The firm is a price taker, so it can sell as much product as it wants at the market price.
  • No matter how much product the firm can sell, it still receives the market price. Thus, the demand for a perfectly competitive firm is perfectly elastic.
• Total Revenue, Average Revenue and Marginal Revenue
  • Total revenue (TR) is the amount of money that a firm receives from selling its output. $TR = P \times Q$
  • Average revenue (AR) is the revenue per unit of output sold. $AR = \frac{TR}{Q} = P$
  • Marginal revenue (MR) is the additional revenue that the firm receives when it sells one more unit of output. $MR = \frac{\Delta TR}{\Delta Q} = P$
• Output Decision in the Short Run
  • Because a perfectly competitive firm is a price taker, it can sell as much output as it wants at the market price.
  • The firm will choose to produce and sell the level of output that maximizes its profit.
• Profit Maximization Rule
  • Marginal revenue (MR) is the revenue that the additional unit of output would add to total revenue.
  • Marginal cost (MC) is the cost that the additional unit of output would add to total cost.
  • If MR > MC, the firm should increase the level of output.
  • If MR < MC, the firm should reduce the level of output.
  • If MR = MC, the firm produces the output level that maximizes its profit.
  • Profit-maximizing condition: $MR = MC$. For a perfectly competitive firm, profit is maximized when $P = MR = MC$
• Long Run Equilibrium
  • Entry eliminates economic profits.
  • Exit eliminates losses.
  • Long-run equilibrium is where firms earn zero economic profits.
• Why Do Competitive Firms Stay in Business If They Make Zero Profit?
  • Total cost includes all the opportunity costs of the firm.
  • Total cost includes the time and money that the firm owners devote to the business.
  • In the zero-profit equilibrium, the firm’s revenue must compensate the owners for these opportunity costs.
  • Economic profit is zero, but accounting profit is positive.
• Monopoly
  • Characteristics of monopoly:
    • Single seller: there is only one firm that supplies a product for the whole market.
    • Unique product: there are no close substitutes for the product.
    • Blocked entry: strong barriers prevent other firms from entering the market.
    • Price maker: the monopolist has the entire market power to set the price for its product.
• Why Monopolies Arise
  • Barriers to entry are the factors that prohibit firms from entering an industry.
  • Three main sources of barriers to entry:
    • Monopoly resources: a key resource required for production is owned by a single firm.
    • Government regulation: the government gives a single firm the exclusive right to produce some good or service.
    • Economies of scale: a single firm can produce output at a lower cost than can a larger number of firms.
• Monopoly’s Demand and Marginal Revenue
  • Total Revenue: $TR = P \times Q$
  • Average Revenue: $AR = \frac{TR}{Q} = P$
  • Marginal Revenue: $MR = \frac{\Delta TR}{\Delta Q}$
  • Because a monopoly is the sole producer in the market, its demand curve is the market demand curve.
  • The monopolist faces a downward-sloping demand curve.
  • The monopolist’s demand and marginal revenue curves are not the same.
  • At any level of output, price is higher than marginal revenue: P > MR. The monopolist’s marginal revenue curve lies below its demand curve.
    A sample set is give showcasing relationships of Quantity, Pirce, and Marginal Revenue. Monopoly’s Output and Pricing Decision
  • The monopolist will choose the level of output where its marginal revenue equals its marginal cost $MR=MC$.
  • A monopolist firm has no supply curve.
  • There is only one combination of price and quantity that the monopolist chooses to supply to maximize its profit.
  • At the optimal level of output:
    • $MR = MC$
    • P > MC: the price that the monopolist charges for its product is higher than its marginal cost.
• Possibility of Losses by Monopolist
  • Pure monopoly does not guarantee profit.
  • If demand is weak and costs are high, then the pure monopolist may incur a loss.
• Price Discrimination
  Price discrimination is a pricing practice that charges different prices for the same product.
• Conditions for Price Discrimination
  • Monopoly power: the seller must have the ability to control output and price.
  • Market segregation: the seller must be able to segregate buyers into distinct classes, each of which has a different willingness or ability to pay for the product.
  • No resale: buyers cannot resell the product among themselves.
• Monopolistic Competition
  • Characteristics of monopolistic competition:
    • Many sellers
    • Differentiated products
    • Easy entry to and exit from the market
    • Each firm is a price maker
• The Firm’s Demand Curve
  • Each monopolistically competitive firm faces a downward-sloping demand curve.
  • The price elasticity of demand faced by each firm depends on the number of rivals and the degree of product differentiation.
  • The larger the number of rivals and the weaker the product differentiation, the greater the price elasticity of each firm’s demand.
• Monopolistic Competition in the Short Run
  • The monopolistically competitive firm maximizes its profit or minimizes its loss by producing at the level of output where $MR = MC$
  • In the short run, the monopolistically competitive firm can either earn economic profit or loss.
• Monopolistic Competition in the Long Run
  • In the long run, firms will enter the market if it is profitable and leave the market if it is unfavorable.
  • Profits → Firms enter: economic profits attract new firms to enter the market, demand for existing firms’ products falls, and their profits decline. Economic profits are eventually driven to zero.
  • Losses → Firms leave: losses cause some firms to leave the market, the demand for existing firms’ product rises, and their losses are reduced. Eventually, the losses will be eliminated.
  • In the long run, firms earn zero economic profit.
• Oligopoly
  • Characteristics of oligopoly:
    • A few large firms dominate the market.
    • Homogenous or differentiated products
    • Mutual interdependence: each firm’s outcome depends not only on its own decision but also on the decisions of other firms. When each firm makes a decision, it has to consider the actions and reactions of other firms.
    • Significant barriers to entry
    • Each firm is a price maker
• The Cartel Theory
  *In a given industry, oligopolist firms will be best off if they cooperate and act as one firm. They form a cartel to act just like a monopolist to capture the maximum level of profit.
  Cartel is an organization of firms that reduces output and increases price in an effort to increase joint profits.
  *Also included, Problems with cartels: Costly to form a cartel, Difficult to reach agreement in formulating cartel policy, Potential of new firms entering the industry, Problem of cheating among cartel members.
• Game Theory
  • In the oligopoly market, mutual interdependence exists among firms.
  • Each firm must make strategic choices based on the consideration of actions and reactions of other firms.
  • Game theory is a mathematical technique used to analyze the behavior of decision-makers who try to reach an optimal position for themselves in strategic situations.
    Illustrations, the Prisoner's Dilemma with strategic analysis. Nash Equilibrium
  • Nash equilibrium is a set of actions for which all players are choosing their best strategies given the strategies chosen by their rivals.
• Dominant Strategy
  • A dominant strategy is a strategy that is best for a player in a game regardless of the strategies chosen by the other players.
    Dominant strategy equilibrium is the outcome when both players have dominant strategies and play them.
    In the prisoners’ dilemma, Anna and Bob both choose to confess.
    When there is no dominant strategy, each player’s strategy depends on the other player’s strategy.
    Example Business Application given regarding Coca Cola.

Market Failures and the Role of Government

• Market failure is a circumstance in which private markets do not bring about the allocation of resources that best satisfies society’s wants.
• Three kinds of market failures: public goods, externalities, and information asymmetries.
• Externalities
  • An externality is a cost or a benefit accruing to a third party (bystander) that is external to a market transaction.
  • Negative externalities: impact on the third party is adverse.
  • Positive externalities: impact on the third party is beneficial.
• Negative Externalities
  • Negative externality creates costs to the third party, called external costs. In a visual depiction shown, market equilibrium is illustrated. With E showing when D = MPB. Social costs will be higher than private costs: $MSC = MPC + MEC$
    • MSC: social marginal costs
    • MPC: private marginal costs (market supply)
    • MEC: marginal external costs
  • The market equilibrium output is the output at which $MPC = MPB$
  • The socially optimal output is the output at which $MSC = MPB$
    Consequences of negative externalities include overproduction and deadweight loss.
    Graphical Illustration of a deadlock loss included. Positive Externalities
  • Positive externality creates benefit to the third party, called external benefit.
    Graphical Illustration of a Positive externality included Social benefits will be higher than private benefits: $$MS